Market Failures and Government Intervention
What are Market Failures & what do they reflect?
 Market prices generally reflect only private costs and benefits.
 The difference between a socially optimum level of production and the market level production
 Market fails because it does not allocate resources efficiently.
 When market creates more good than harm
Inefficiency of Market Failures
 Productive inefficiency: businesses are not maximizing their outputs because the cost of making more output it
higher, so the productivity of a company becomes lower.
 Allocative inefficiency: businesses misallocate resources and produce goods and services that are not wanted by
the consumers (may be cheaper to produce)
Government Intervention
 Government intervention aims to achieve economic efficiency and attempts to correct and internalize the market
failure.
Root Causes of Market Failures
 Externalities in production and consumption
 Public Goods (missing market)
 Lack of Competition (Monopoly)
 Poverty and Inequality in an Economy
Marginal Analysis of Externalities
 Marginal Private Benefit (MPB): belongs to the producer or consumer of the good.
 Marginal External Benefit (MEB): the spillover.
MPB + MEB = Marginal Social Benefit (MSB)
Positive Externality
 Marginal Private Cost (MPC): the cost incurred by the producer or consumer.
 Marginal External Cost (MEC): is the spillover or the externality.
MPC + MEC = Marginal Social Cost (MSC)
Government Approaches to Externalities
Quantity Control (Most common form of Government Intervention)
 A form of government regulation that regulations the production of a
good/service.
 Quota limit: the total amount of a good that can be produced under the quantity
control.
 Licenses issues to allow production
Negative Externality
 Quantity controls typically create undesirable side-effects:
 Inefficiencies, or missed opportunities (mutually beneficial transactions that don’t occur)
 Incentives for illegal activities
Subsidies (Used when there is an under allocation of resources)
• To correct spillover benefits, government often uses subsidies
• Subsidies can be paid either to the buyers or the sellers.
•
Subsidies create undesirable side-effects:
 Inefficient producers are able to remain in business & taxpayers must pay more taxes
Tax on Producers (Implemented by government)
 To solve negative externalities excise taxes are implemented to
raise marginal cost and decrease supply.
 But producers then increase selling price, and pass on their
costs to buyers to maintain the profit margin.
 Taxes on producers create the following undesirable sideeffects:
 Inefficiency (excess burden or deadweight loss) &
illegal activity in attempts to avoid the tax.
Public Provision of Goods and Services
 Government provides previously decided upon public goods with tax
money collected from all citizens.
 Government can’t use price as a signal of value in the way that a market would, because price does not fully
reflect the value of most public goods.
Monopolies Resulting in Market Failure
 Increased competition means that a market is more likely to provide the socially optimal amount of a good, and
reach allocative efficiency
 Some markets will collude to create a monopoly, but government aims to make industry more competitive.
Government Solutions to Monopolies
 Antitrust Policies: Laws that aim to curb monopoly power and make the following practices illegal:
 Collusive price fixing, separation of markets, tying contracts and interlocking directorates
 Antitrust laws strengthen government powers to promote competition.
Disparities in the Distribution of Resources Resulting in Inequality

Failure to properly distribute income leads to a inequality (a form of market failure)
 Change in technology and outsourcing, has decreased demand for unskilled labour and made their incomes
extremely low.
Solutions to Inequality
 Policies that are imposed to decrease Inequality include:
 Minimum wages: If labour is inelastic, this policy is effective at reducing inequality.
 Welfare: government programs that supplement the income of the needy
 Negative Income Tax: High income families pay tax, low income families receive money
 In-kind Transfers: Things given to the poor in the form of goods and services
Measuring Inequality- The Lorenz Curve
 The Lorenz Curve: A curve that shows the degree of inequality in the distribution of income in a society
 The pink shaded area labelled A represents inequality present in a society.
 The Gini Coefficient find the percentage of inequality.
Factor Distribution and the Gini Coefficient
 Gini coefficient: an number between zero and one
that is used to measure inequality as it relates one variable
to another. For perfect inequality the Gini coefficient is 0
absolute inequality yields a coefficient of 1.
 The Gini Coefficient can be found from the Lorenz Curve
by dividing area A by the combination of area
A and B. Thus, A/(A+B).
 Factor Distribution of Income: is the division of total
income among labor, land and capital.